Friday, August 2, 2019

How Using the Word "MAY" Instead of "WAS" Can Cost You $100 Million

On July 24, 2019, the SEC charged Facebook Inc. $100 million for inaccurately disclosing the risk of misuse of user data.  Facebook agreed to pay, without admitting or denying any wrongdoing.  So, what happened?

According to the SEC complaint, the Facebook public filings (such as the annual reports on Form 10-K or the quarterly reports on Form 10-Q, etc.) informed the public that "our users' data MAY be improperly accessed, used or disclosed" (emphasis added), but in fact, at that time Facebook already knew that it was true.  It all goes back to the infamous Cambridge Analytica scandal (CA paid an academic to collect and transfer from Facebook certain data in violation of the Facebook policies).  Later, CA used such data for clients' political campaigns.  According to the SEC complaint, Facebook discovered the misuse by December 2015 but failed to correct its public company disclosure until May 2018.

This was a material risk, and in Facebook's case, it became a reality.  However, the company did not move it from the category of "possible risks" to the category of "real events".  Rule 10b-5 under the Securities Exchange Act (like Section 17(a)(2) of the Securities Act which is near identical) prohibits companies to make "any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading...".  Most securities lawyers know this phrase verbatim.   Perhaps, there was a question of whether such information was "material" to Facebook's stockholders (there are ongoing debates about the materiality standard, although in this case misusing data of 30 million Facebook users does sound "material").  Perhaps, Facebook management did not actually know about what was happening or was in disbelief.  Perhaps, some people knew but failed to communicate it to others with the disclosure-making responsibilities.  Whatever the explanation is, the fact remains that after Facebook finally publically announced that it knew about the data breach, its share price dropped, underscoring the importance of this information.  Well, this turned out to be a costly misuse of the three letters MAY. 

Drafting disclosure documents is not creative writing.  This skill is rooted in the deep understanding of the legal standards, the industry, the company, and the specific risks the company faces.  It is also based on the information that is being made available to the drafter.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  

Tuesday, July 30, 2019

Utility Tokens Exist

On July 25, 2019, the SEC issued its second no action letter that enables a company to generate and sell digital tokens that are not "securities" within the meaning of the US securities laws.  This no-action letter provides a no action relief to Pocketful of Quarters, Inc. ("PoQ") that intends to sell Quarters (its native digital tokens) to gamers for use in connection with playing games of the participating developers on their platform.  Just in April of this year, the SEC issued a similar no action letter to TurnKey Jet, Inc.

Below are my observations regarding this no action letter and token issuance in general:
  • This second no action letter helps us delineate the universe of utility tokens.  They are not just a concept that was abused and misused in the 2017-2018 ICOs.  Utility tokens can legally exist within the legal framework of the US laws.    
  • If previously the SEC had only shown us the instruments that cannot be utility tokens (through its cease and desist orders and various enforcement actions), then now, for the second time, we are shown examples of tokens that can be and are utility tokens.  This is incredibly useful guidance when advising clients on how to structure their tokens.
  • PoQ financed the development of its gaming platform through the issuance and sale of Q2 TOkens that were treated as "securities".  The Quarters that are subject to this no action letter are being issued after the platform development has been completed.  Again, this approach (issuing two types of tokens) can be used by others when conducting their token offerings.  
  • Quarters are not redeemable by gamers.  Once purchased, Quarters can only be used within the platform to play games, purchase upgrades, and participate in tournaments.  The only persons who can redeem the Quarters are the participating pre-approved developers and influencers who can earn the tokens by developing games and marketing them to the gamers.
  • Quarters will be sold at a fixed price, and there will be an unlimited supply of them.  This means that there will be no price speculation and no shortage that could affect the price.
  • Quarters cannot be transferred to other gamers, and therefore Quarters cannot be, and will not be, traded on secondary markets.  This means that gamers would not be purchasing the tokens with an expectation to make a profit.
  • Quarters will be sold only for the gamers' personal use within the gaming platform.  
  • Quarters will not be marketed to the public as an investment, and PoQ will make corresponding disclosures in its marketing literature.
As described in the thorough and well-written incoming letter, the Quarters present an example of true utility tokens that others may be tempted to replicate.  However, it is important to remember that only the recipient of the no action letter can legally rely on it.  Other tokens will have different features that may or may not support the legal outcome that these tokens are not "securities".  But still, the PoQ no action letter presents a good model of how to structure an offering of utility tokens that should be studied by the future token issuers.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  

Sunday, July 21, 2019

Blockstack: First Reg A+ Token Offering

On July 10, 2019, the SEC qualified the first digital token Regulation A+ offering.  This is an important event that could open the gates for other Regulation A+ token offerings that have been patiently waiting for their turn.

It was Blockstack that, after a 10-month wait, was approved for the $28 million offering.  According to Blockstack's offering circular, purchasers of the tokens will not be buying anything that resembles securities in a traditional sense.  Instead, they will receive utility tokens usable on the Blockstack network that consists of a Blockchain platform for developers to build applications.  Tokens are being sold to three groups of people: (i) to the existing holders of certain vouchers, at a discount; (ii) to the general public; and (iii) to app developers and reviewers as rewards.   The offering is being conducted directly by the company through its own website, www.stackstoken.com, where qualifying prospective purchasers can sign an online subscription agreement and transfer the money (at least $100) either in US dollars, Ether or Bitcoin. The tokens will not be sold to the residents of Arizona, Nebraska, North Dakota or Texas.  Union Square Ventures, already a 15% equity holder in Blockstack, has indicated interest to purchase $1 million worth of tokens.  Blockstack expects to issue the tokens 30 days after the close of the cash offering, at which time all proceeds raised in the offering will be released from escrow.  Although the tokens will be unrestricted securities under federal securities law, initially, tokens will not trade on any exchange and will be "time locked", which means that purchasers will not be able to use (or "burn") the tokens on the Blockstack platform.  About 1/24th of tokens will be released from the time lock every month.  Concurrently, Blockstack is selling its tokens in Regulation S private offering to non-US investors.  These tokens will be restricted securities. 

It is still uncertain that the Blockstack qualification would, in fact, lead to other Regulation A+ token offerings.  After all, they paid $2 million in legal fees to get the SEC approval, according to the WSJ article and, according to the company's offering circular, their overall expenses related to the offering amounted to $2.8 million.  This is a hefty price tag for a "registered ICO" that others may not afford.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.